A year after becoming an equities exchange, BATS plans to grab a chunk of the options market through aggressive pricing that appeals to some of the same automated liquidity-providing firms that helped make it the third-largest exchange operator in U.S. equities.
"Compared to our competitors in this space, we’re lean, based on our direct monthly expenses and capital outlay to get into options, so we’re operating on a different scale than other exchanges," said Joe Ratterman, CEO of BATS Exchange. "Because of that, we can be aggressively priced."
BATS Options will have maker-taker pricing in a price-time market model. The exchange hasn’t yet announced its pricing, but will target all options classes, and not just those quoted in penny increments, Ratterman said. He does not think the exchange will offer different pricing for penny-quoted and non-penny-quoted options, but noted that the final decision hasn’t yet been made. In equities BATS has sometimes used inverted maker-taker pricing to attract volume.
"If history is any guide, they’re very aggressive with their pricing metrics, and will enter the options space with a pricing structure that will undercut the competition and will attract interest and competition from trading entities," said Andy Nybo, a principal at research firm TABB Group.
BATS’s ambitions for options are aggressive. "We wouldn’t be going into this market if there wasn’t a big opportunity for BATS to come in, make improvements and gain market share," Ratterman said. "U.S. equities was one of the most competitive markets in the world and we managed to do very well when we broke into that space. There’s nothing to keep us from being successful in options."
Ratterman expects BATS’s eventual options market share to equal its share in equities. In June, BATS accounted for 10.7 percent of equities volume. BATS, formerly an ECN, opened for trading in January 2006 and became an exchange in August 2008.
BATS intends to build its options market by appealing to a range of investors, including institutions, retail brokers and market-making firms. "We’ll attract as much diversity [of flow] as possible," Ratterman said. "We have a fair and open model in the equities world and will have that in options."
But the exchange’s strong suit is its appeal to automated market makers. "The performance metrics of our system have traditionally appealed to automated market-making firms because of the low-risk characteristics of their trading on our markets, and the consistency and performance of our system," Ratterman said. "It’s likely we’ll have as much influence on the options side."
TABB’s Nybo notes that BATS’s reputation for having a strong technology platform and low-latency infrastructure will boost its prospects in options. "They are looking to attract quantitative trading firms using low-latency, high-frequency strategies and those that arbitrage fleeting price discrepancies," he said.
BATS will file the rule set for its new market "shortly," according to Ratterman. He said the launch of BATS Options is targeted for January or February of next year, subject to approval by the Securities and Exchange Commission.
BATS Options will join a growing marketplace populated by seven options exchanges. Last month, 296 million equity options contracts changed hands, up 5.6 percent over the previous June’s volume. The industry traded a record 3.3 billion equity options contracts in 2008, an increase of 26.7 percent over 2007’s record volume. This year is on pace to exceed last year’s volume.
At the same time, the options market is undergoing tremendous change that has resulted in new competition among exchanges. An SEC-facilitated pilot, launched in January 2007, led to some options being quoted in penny or nickel increments. The resulting shrinkage in spreads for those names has fueled the growth of price-time priority exchanges with maker-taker pricing that rewards liquidity providers for limit orders and charges takers a fee. This model contrasts with the traditional pro-rata model that’s structured around payment for order flow and trading priority for customers.
Four of the current seven exchanges have pro-rata models with priority for customer orders, while the other three have price-time priority markets with maker-taker pricing. The former group includes the Chicago Board Options Exchange and the International Securities Exchange, the industry’s two biggest markets. The price-time maker-taker group includes NYSE Arca, the Boston Options Exchange and Nasdaq Options Market. Arca and BOX have standard (non-maker-taker) pricing for options that aren’t in the penny pilot, while Nasdaq has another pricing scheme for those names.
The growth of the options industry has fueled intense competition, although which exchanges will benefit the most in the future is unclear. "There is room for new trading venues and multiple market models," said Molly McGregor, spokesperson for the ISE. "We welcome the additional competition in this space if it improves liquidity in the industry. We all hope to benefit from that."
The CBOE, for its part, is in the process of launching a second options exchange. It expects that exchange, which must be approved by the SEC, to roll out later this year. That exchange, currently called C2, is targeted at high-frequency trading firms, many of which have servers in the New York City area. C2’s matching engine will be in Secaucus, New Jersey.
TABB’s Nybo thinks a potential expansion of the penny pilot, which is now being debated, will benefit primarily exchanges with maker-taker pricing. "A maker-taker model is more attractive when there are smaller price increments," he said. "For penny issues, the maker-taker model is more conducive to strategies looking to earn rebates. As there’s increased volume in penny issues, more volume will transition to maker-taker exchanges."
Currently more than half of the industry’s volume is in penny-quoted names. By 2011, TABB predicted in a recent report, 21 percent of options volume in the current pilot names will be subject to maker-taker pricing at exchanges with price-time priority models, up from 12 percent. Nybo noted that while 18.3 percent of options volume in the first quarter of this year executed at Arca, Nasdaq and BOX, about 12 percentage points was in penny names subject to maker-taker pricing.
Brian Nigito, head of the New York office of GETCO, one of the largest market-making firms in equities, said his firm believes that an expanded penny pilot would create "an opportunity to further increase efficiencies and lower trading costs in the options market, providing options investors with the same benefits as participants in the cash markets." If the penny pilot is expanded, he said, more of the industry’s market share would likely flow to exchanges with price-time priority and maker-taker pricing. GETCO is an equity investor in BATS Global Markets, the parent company of BATS Exchange. BATS’s other 10 stakeholders include JPMorgan, Citi, Morgan Stanley and automated market-maker Tradebot Systems.
But even if maker-taker pricing gradually claims more of the industry’s market share, the balance of power between market models might not shift too swiftly. BOX, the first exchange to offer a price-time priority model, in 2004, earlier this month abandoned maker-taker pricing for three of the most active penny-quoted options classes. For SPY, QQQQ and IWM options, BOX switched to traditional pricing and customer priority.
"It would probably be a mistake to read too much into BOX’s decision to drop make or take pricing on SPY, QQQQ and IWM options," said Will Easley, vice chairman of BOX. He noted that these are among the most liquid, actively traded options classes, with narrow bid-offer spreads that leave "little room for improvement of the NBBO." BOX’s market share was 3.9 percent last month, compared with 5.8 percent in June 2008.
Easley noted that BOX would probably gain more volume by appealing to non-broker-dealers. In an email, he wrote: "BOX concluded that the make credit of 20 cents paid to liquidity makers was not sufficient to incite prices better than the already very tight NBBO on these three classes, and decided therefore to eliminate take fees in order to attract the public customer flow that it had lost due to the unpopularity of take fees with this segment of the marketplace."
Ratterman acknowledges that retail brokerages have, by and large, opted for pro-rata models. But in his view, "the lack of transparency around payment for order flow is not best for the end-user and investor." He believes these firms will eventually change their order-routing practices. "We’re entering on the right side of the market," he said. "There is more momentum behind the transparent maker-taker model."
